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A covered option is a situation in which an investor owns a stock and also sells options on the same stock. Covered options will reduce, but not eliminate, the risk of a change in the price of the underlying security. An investor will typically use a covered option if he believes that the price of the stock will remain relatively flat in the short term, but will appreciate over the long term.
There are two types of options: A put option and a call option. The put option gives the owner the right to sell stock at a stated price within a stated time frame. The call option gives the owner the right to buy stock at a state price within a state time frame. Note that the owner of an option is not required to exercise the option, and will not do so if the price does not make it profitable to do so. The person who issues, or sells, the option is called the writer of the option. If an investor owns only the option, and not the underlying security, he is said to have a naked option.
An investor who owns a particular stock, which is known as being long in the stock, and also sells a call option, is said to have a covered call option. In this case, if the stock price falls, the buyer of the option will not exercise it, and the writer of the option will profit by the price of the call. He will still retain the stock, although its value will have decreased. If the price remains flat, the writer will also profit from the sale of the call, and the stock price will remain the same. If the price of the stock goes up and the call is exercised, the writer of the call will profit from the price of the option, plus the increase in the price of the stock. He will no longer own the stock, however, and so will not participate in future appreciation of the stock.
If an investor is long in a stock and sells a put option and purchases a put option on the same security, he owns another kind of covered option known as a married put. A married put offers protection against a drop in the stock price. If the stock price declines below the strike price of the covered option, the investor can exercise the put and sell the stock at the strike price. If the price of the stock increases, the investor would let the option expire, and sell the stock at the higher market price, profiting by the gain over the purchase price of the stock. This type of covered option limits the investor’s potential loss and allows for virtually unlimited profit.